Many companies use Stock Options as equity compensation to attract and hire the right people for their teams. Stock Options are designed to motivate employees, directors, consultants, and advisors to help build a more valuable company because they will have the opportunity to participate in the company’s financial upside as future equity owners of the company.
Stock Option Plans and grants are more complex than what you initially might expect. They involve a varying combination of corporate, securities, tax and employment law issues, which require “squeaky clean” compliance and administration to stay out of legal trouble and preserve the value of the stock option grants.
A key term of each Stock Option is its Exercise (or strike) Price, because the Exercise Price is a very important component in determining the potential value of the Stock Option. If the Exercise Price is set too high, then the Stock Option may not serve as a good motivational tool, as the grantee’s potential upside may be limited. If the Exercise Price is set too low, then the grantee may face potential tax liability (more on that below).
As a simple example, if you receive a Stock Option exercisable into 10,000 shares of Common Stock at an Exercise Price of $0.10 per share and the company later is acquired at a valuation equal to $10.00 per share, then, assuming that your Stock Option is fully Vested, you can purchase the 10,000 shares for $1,000 (i.e., at the Exercise Price of $0.10 per share) and sell the shares as part of the acquisition for $100,000 for a pre-tax gain of $99,000. As you can see, the Exercise Price has a significant impact on the value of a Stock Option award.
Our clients often ask us how they should set the Exercise Price under their Stock Option awards. Unfortunately, the process involves more than just holding a finger to the wind and picking a price per share that seems right. Before we get into valuation methodology, it’s important to understand the legal requirements for setting the Exercise Price for your Stock Options.
Tax Issues and Fair Market Value
Internal Revenue Code Section 409A (Section 409A Valuation) regulates how your company treats “nonqualified Deferred Compensation” (i.e., compensation that workers earn in one year, but that is paid in a future year), which is given to employees and other “service providers” for federal income tax purposes. This nonqualified Deferred Compensation includes stock options, stock appreciation rights and other similar forms of equity-related compensation. Section 409A is a complex area of the tax code and your company’s failure to comply can subject your employees and other option recipients to significant and immediate tax liability.
The federal tax laws (and tax laws of certain states) require that the Exercise Price of a Stock Option must be equal to (or greater than) the fair market value (FMV) of the underlying stock when the Stock Option is granted. A significant tax issue may arise later for the Stock Option recipient if you cannot show that the Exercise Price was set at or above the FMV when the Stock Option was granted, which, in some cases, may result in a combined federal and state tax hit of up to 85% (or more) as the Stock Option vests.
Additionally, when the exercise price is set below FMV at the time of option grant, Section 409A requires that the option holder immediately recognize taxable income equal to the difference between the Exercise Price and the then current FMV of the option shares as they vest. To make matters worse, not only will a higher tax rate be applied to this spread, but the tax also is applied to an amount that the option holder has not actually received as income and the related shares likely cannot be sold at that time to help cover the tax liability. In the case of employees, your company also will need to withhold the taxes, or it could be on the hook for such taxes and related penalties and interest.
Determining the FMV of the company’s stock when granting Stock Options therefore is an extremely important issue both for the option recipient and your company.
So, How Do You Determine FMV?
Without question, it is very difficult to value the stock of a private company, especially when it is a startup or early-stage company.
Fortunately, under Section 409A, the Internal Revenue Service (or IRS) has approved three “safe harbor” valuation methods that private companies can use to determine the FMV of the stock underlying its Stock Option grants. A qualified person (based on knowledge, experience, training, etc.) needs to perform the stock valuation, using the “reasonable application of a reasonable valuation method.”
By consistently using one of these approved valuation methods, your company no longer has the burden to prove that a reasonable valuation method was used to determine FMV, and the burden shifts to the IRS to show (e.g., in an audit) that either the valuation method or its application was grossly unreasonable. This shift in the burden of proof to the IRS lowers the likelihood that the IRS will be successful in challenging the FMV used by the company. Your company also can rely on the FMV determined by these approved valuation methods for up to 12 months, unless your company experiences certain changes, events and/or developments that materially impact the prior FMV determination, such as a significant commercial transaction or a new round of funding.
Method 1. Independent Appraisal (i.e., 409A Valuation):
Under Section 409A, your company can hire an independent appraiser to determine the FMV of the stock for option grant purposes. These valuation experts must use valuation methods specified by Section 409A. As you might imagine, an entire industry exists to support these valuations and the cost ranges from as low as $2,000 to up to $5,000 (and sometimes much more) depending on your company’s particular status and needs. Remember that you often get what you pay for and you need to make sure that you (and the appraiser) follow the IRS rules so that your company can benefit from this IRS safe harbor. Most companies that have received significant angel or VC investment rely on this valuation method to determine the FMV of the stock.
Method 2. Illiquid Startup Valuation:
Your company also can rely on a stock valuation if performed by someone (including an employee of your company) that your company reasonably has determined to be qualified to perform such valuation based on significant knowledge, experience, education or training in conducting valuations. Section 409A provides that the significant experience requirement can be met with at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending or similar experience in the company’s line of business or industry.
In addition, among other requirements, your company cannot have conducted business for more than ten years and cannot reasonably anticipate an IPO within the next 180 days or an acquisition within the next 90 days. The stock valuation must be in writing and the valuation factors listed in Section 409A must be addressed. Also, the stock being valued cannot be subject to put or call rights, excluding rights of first refusal and stock repurchase rights related to a termination of service. This valuation method is often used by companies that are pre or post-seed funding. While this valuation method may be lower cost, it could subject your company to greater scrutiny and challenge by the IRS, so you will need to make sure that all of the safe harbor requirements are met for this valuation method.
Method 3. Non-Lapse Restriction Valuation:
This safe harbor valuation method is based on a formula that, if used as part of a specific restriction that never lapses and permanently limits the transferability of the stock, would be considered the fair market value of the stock for purposes of Internal Revenue Code Section 83(b) (Section 83(b)). To be considered reasonable, this valuation method must be used consistently for various compensatory and non-compensatory purposes. Needless to say, this valuation method is not used very often to determine the FMV of the stock underlying stock option grants.
Valuation Methods Outside of the Safe Harbor
If your company chooses not to pursue one of the safe harbor valuation methods above, then it will be important to create a written record to show that your company and its Board of Directors considered all relevant and available information that was material to the company’s FMV determination at the time of grant, including various quantitative and qualitative factors and the related analysis and computations. Also, if your company does not use one of the safe harbor valuation methods, then it cannot rely on the 12-month applicability period and it later may face the burden of proving to the IRS that its FMV determination for the stock underlying its stock option grants was reasonable given the company’s specific facts and circumstances – possibly a tough burden after the fact and if there is not a strong written record. Your company and its Board of Directors will need to make sure that your company is willing to shoulder this risk given the potential tax liability and financial consequences both to the option holders and your company. You may want to consider indemnification agreements for the officers and directors and, to the extent feasible, D&O insurance if your company steers away from one of the safe harbor valuation methods.
Early Stage – Consider Restricted Stock
Many Early-Stage Companies or Startups are tight on cash and may resist engaging an independent appraiser given the cost of valuation method #1 above. These companies also may not have someone available with the experience and training for valuation method #2 above. As an alternative to Stock Options, your company could consider granting Restricted Stock at this early stage, because Section 409A generally does not cover Restricted Stock grants and a valuation error may not create the same level of problems as with Stock Options. Remember, however, that the Restricted Stock grants still may present tax issues at the time of grant (i.e., the difference between the FMV of the Restricted Stock and a lower price paid is taxable income) and the new Stockholders likely will need to file 83(b) Elections with the IRS to avoid income taxes as the Restricted Stock vests.
In addition to the risks and potential liability mentioned above, future investors and acquirers will want to know that your company has complied with these Stock Option valuation and tax matters, so it is not wise to simply brush them aside. Given the complexity of this area and the potential financial consequences, it is extremely important that your company seek the necessary professional help to your company administer its stock option program and comply with the requirements of Section 409A.
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